Understanding bonds

If you're thinking about putting your money into bonds, it's essential to understand how they work and to keep an eye out for the important factors that can affect them. This knowledge will help you make informed investment decisions.

What is Bond?

Bond is a financial instrument used by governments and corporations to raise capital by borrowing money from investors. As an investor in bonds, you lend money to the issuer for a predetermined period of time and coupon rate.

In return, you can expect to receive regular coupon payments, which are a percentage of the bond's principal value. When the bond reaches maturity, the issuer repays you the principal value. Bonds can be a great investment option, as they offer returns in the form of both interest income and capital gains, which occur when the bond's price increases from the time of purchase. It's crucial to keep in mind that even though the coupon rate remains fixed, the price of a bond can fluctuate, which can affect your potential for gains or losses.

That's why it's important to take into account both the coupon payments and the possibility of changes in the bond price when assessing a bond's return. By doing so, you'll have a more complete picture of the potential returns and risks associated with investing in a particular bond.

Coupon Rate: The issuer of the bond compensates the bondholders by paying them interest; the rate of interest is called the ‘coupon’ rate. The rate of interest or coupon payment varies depending upon the economic circumstances, the creditworthiness of the issuer, type of bond, maturity, etc.

Credit rating: Each listed bond holds a rating provided by credit rating agency(ies). A higher rating suggests a lower amount of risk and lower yields and a lower rating may be indicative that the risk involved in the bond is higher along with higher returns.

Understanding the Factors that Affect Bond Coupon Rates

Bond coupon rates primarily depend on credit rating and creditworthiness of the issuers. Credit rating is an evaluation of the issuer's creditworthiness. Bonds issued by companies or governments with high credit ratings usually offer lower coupon rates because they are considered less risky. In contrast, bonds issued by companies with poor credit ratings may offer higher coupon rates to offset the higher risk involved.

Important things to remember before investing in bonds

Before you invest in bonds, don't rely solely on credit ratings. These ratings are just one opinion from a credit rating agency, and they can change quickly. To understand if a company can pay back its debts, you need to look at other things i.e. past bond issues and how profitable they are.; solvency ratios and other credit metrics can also help you assess a company's financial health

Further, you need to decide how long you want to keep the bond and whether you want to invest in government or corporate bonds.

Remember that there's no guarantee that any investment will be successful, so do your research and consider all the factors before investing. Investing in bonds can be risky as you may lose some of your invested money if you sell your bonds before they mature. The bond prices may fluctuate due to market conditions and the issuer's creditworthiness. But the risk gets bigger if the issuer defaults on the bond.

Risk of investing in Bonds

Bonds carry some risks that you should be aware of, including:

• Default risk: This means that the issuer may not be able to pay back the money you've lent them, which can happen due to changes in the economy or the issuer's financial situation.

• Interest rate risk: When interest rates rise, bond prices may fall, and vice versa.

• Liquidity risk: If you need to sell your bond before it matures, its price may be affected by market conditions. If there are few buyers, you may have to sell at a loss.

• Call risk: Some bonds may be bought back by the issuer before their maturity date. This means you may not be able to reinvest in a similar product with the same yield.